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Tuesday, December 11, 2012

The story is told of René Descartes getting a flash of brilliance as a young teenager that led to the Cartesian co-ordinate system that brought together algebra and geometry. Young Descartes gave a visual depiction of algebraic equations by plotting points relative to an origin. In this, he developed a concept that belongs in a broader family of concepts that compare and classify things - something that humans love to do and that is necessary for any type of analytical work.

Here's another example: suppose one basketball player makes 79 of 112 foul shots and another made 57 of 89. Who has the better record? The comparative device here--the device that puts them on the same footing--is the percentage calculation. The first player made 70.5% of his or her shots and the second player made 64 percent. Percentages make comparisons of these types simple, and they are used almost without thinking. Take a stroll through Costco and you'll see people with calculators figuring the per ounce cost of 2 different cans of tuna.

For investment analysts, the most widely-used comparative metric is the P/E ratio. Ask whether stock ABC is a better value than stock XYZ and, invariably, the very first number you will get is the P/E ratio, where P is price and E is earnings. In fact, as you read views on the likely direction of the overall market, you will frequently see references to the market P/E relative to historical P/E.

So let's back up and think about this. Suppose I told you that stock ABC is earning $1.50 per share and stock XYZ is earning $.75 per share. Is ABC the better value? When you reflect on this a bit, you realize that you really can't say. ABC may have a price of $30 and XYZ a price of $10. The price of ABC is 3 times the price of XYZ, but its earnings are only 2 times as much.

All of this is equalized and put on a comparative basis by the P/E ratio. For our example, ABC has a P/E ratio of 20 and XYZ 13.33. We say that for ABC "you have to pay $20 per dollar of earnings," etc. Thus, from this perspective, it is easy to see that ABC is more expensive, i.e., you have to pay up for a dollar of earnings for ABC.

But this is just the first step. It may very well make sense to pay up for ABC. It depends on its expected growth. Studying P/Es is just the first step. But it is a huge first step.

As you study P/Es, you quickly come to realize there are various measures. There are P/Es based on trailing earnings (ttm stands for "trailing 12 months") and there are P/Es based on expected earnings. There are also P/Es based on normalized earnings that use adjustment techniques to get at the underlying trend.

Here, for example, is what you get on Yahoo! Finance for Johnson & Johnson:

Source: Yahoo Finance

CLICK IMAGE TO ENLARGE Check that the P/E ratio of 23.08 is correct by taking the price 70.45 and dividing by EPS of 3.05.

P/Es are also used to classify investment approaches. For example, value managers focus on lower-than-average P/E stocks whereas growth managers focus on stocks that have higher P/Es whose earnings are growing faster than average.

As mentioned above, P/Es are also used to assess the overall value of the market. One of most popular is the Shiller P/E 10 ratio. This measure uses 10 years of earnings adjusted for inflation. It is used by so-called tactical asset allocators and market timers to assess entry and exit points in the U.S. stock
market. Here is an update Shiller P/E ratio graph fromgurufocus:

Homework Problems:

1. Find the P/E ratios of VZ, MON and MSFT. Which of these stocks do you believe is the value now? (Hint: go to Yahoo! Finance and put in ticker symbols.)
2. According to the Shiller Price/Earnings Ratio, is now a good time to invest in U.S. stocks?

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I've managed investment assets for institutions and individuals for more than 30 years and have seen first hand the egregious fees charged for sub par performance. My mission is to show individuals how to avoid these fees and capture the long term performance of the markets. In doing this I consult on an hourly basis, manage assets for a short period to get investors set up to manage on their own and manage assets outright at less than half the going rate.
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